Free Cash Flow To Firm - definition & overview

In the dynamic world of small businesses, understanding financial metrics is not just a necessity, but a stepping stone to success. One such critical metric is the 'Free Cash Flow to Firm' (FCFF). This term, often used in financial analysis, is a measure of a company's ability to generate cash that is free to be distributed among all the security holders of a company. These include equity holders, debt holders, preferred equity holders, and convertible security holders.

FCFF is a significant indicator of a company's financial health and is often used in valuation models. It provides a clear picture of the cash available to investors after all business expenses, capital expenditures, and working capital requirements have been met. It is a measure that truly reflects the financial flexibility and strength of a company.

Calculation of Free Cash Flow to Firm

The calculation of Free Cash Flow to Firm may seem complex, but it is a straightforward process once you understand the components involved. The formula for FCFF is as follows: FCFF = EBIT x (1-Tax Rate) + Depreciation & Amortisation - Changes in Net Working Capital - Capital Expenditure.

Each component of this formula has a specific meaning and significance. EBIT stands for Earnings Before Interest and Taxes, which is a measure of a firm's profit that includes all expenses except interest and income tax expenses. It is often referred to as operating earnings or operating profit.

Understanding the Components

The Tax Rate is the corporate tax rate applicable to the company. Depreciation and Amortisation are non-cash expenses that reduce the company's taxable income. Changes in Net Working Capital reflect the difference in current assets and current liabilities from one period to the next. Capital Expenditure, often abbreviated as CapEx, refers to the funds used by a company to acquire, upgrade, and maintain physical assets.

By understanding each component, you can see that the FCFF formula essentially calculates the company's earnings, adjusts for non-cash expenses and changes in working capital, and subtracts the money spent on maintaining and expanding the business's physical assets. This gives a clear picture of the cash available to be distributed to investors.

Importance of Free Cash Flow to Firm

The importance of Free Cash Flow to Firm cannot be overstated. It is a vital tool for investors, creditors, and the company itself to assess the firm's financial health and growth potential. FCFF provides a clear picture of the company's ability to generate cash that is free to be distributed among all the security holders of a company.

For investors, FCFF is a critical measure as it shows the cash available for distribution to equity holders after all expenses and reinvestments. It is a more accurate measure than mere earnings or net income as it accounts for the investment needed for future growth.

For Creditors and Lenders

For creditors and lenders, FCFF is a crucial metric as it reflects the company's ability to service its debts. A positive FCFF indicates that the company generates more cash than is required to cover its expenses and investments, implying that it has sufficient funds to meet its debt obligations.

Moreover, FCFF is a more reliable measure than earnings or net income as it is harder to manipulate with accounting tricks. Therefore, it provides a more accurate and reliable picture of the company's financial health.

Limitations of Free Cash Flow to Firm

While FCFF is a powerful tool in financial analysis, it is not without its limitations. One of the main limitations of FCFF is that it does not consider the cost of debt. While it shows the total cash available to all investors, it does not reflect the cost of borrowing.

Another limitation is that FCFF can be significantly affected by changes in working capital, making it volatile from one period to the next. This can make it difficult to use FCFF for comparative analysis or trend analysis.

Depreciation and Amortisation

Depreciation and Amortisation are non-cash expenses that can have a significant impact on FCFF. Different depreciation methods can result in different depreciation expenses, leading to variations in FCFF. This can make it challenging to compare FCFF across companies that use different depreciation methods.

Moreover, while depreciation and amortisation are non-cash expenses, they represent the wear and tear of physical assets. Therefore, a company with high depreciation and amortisation may need to make significant reinvestments in the future, which is not reflected in the FCFF.

Free Cash Flow to Firm in Valuation

Free Cash Flow to Firm plays a crucial role in business valuation. It is often used in the Discounted Cash Flow (DCF) model, which is a method of valuing a company based on the idea that a business is worth the present value of its future cash flows.

In the DCF model, the future free cash flows to the firm are projected and then discounted back to the present value using the company's Weighted Average Cost of Capital (WACC). The sum of these present values gives the enterprise value of the company.

Weighted Average Cost of Capital

The Weighted Average Cost of Capital (WACC) is the average rate of return a company is expected to provide to all its security holders to justify the risk of the investment. It is used as the discount rate in the DCF model.

WACC takes into account the relative weights of equity and debt in the company's capital structure and the cost of each. Therefore, it provides a more accurate discount rate than using the cost of equity or cost of debt alone.

Conclusion

Free Cash Flow to Firm is a powerful tool in financial analysis and business valuation. It provides a clear picture of a company's ability to generate cash that is free to be distributed among all the security holders of a company. While it has its limitations, its benefits far outweigh them, making it a critical measure for investors, creditors, and the company itself.

By understanding and effectively using FCFF, small businesses can not only assess their financial health but also attract investors and secure loans. It is a testament to the fact that in the world of business, knowledge is not just power, but the key to success.